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In our latest edition of Tech Bytes, the Fundamental Equity team takes a look at how the evolution of the Metaverse may impact the broader tech ecosystem and shape future investment opportunities. We also dig into other topics that are top of mind for clients, including: how competition in the e-commerce space has intensified as companies invest in fulfillment; how we foresee the Chinese online advertising market evolving; how we are navigating the effect of geopolitics on an already tight supply-demand situation in semiconductors; and how Unified Communications as a Service (UCaaS) has grown in response to shifting workplace needs.
The Fundamental Equity Tech team comprises 16 investors with an average of 17 years of experience, and it manages over $14 billion in dedicated technology portfolios.
Q: The Metaverse: it’s a challenging concept for many people to wrap their heads around at this stage of its development. How would you define it?
Sung Cho: There are many ways to describe the Metaverse. We believe the Metaverse is an evolution of the Internet. It describes an environment in which there are persistent, shared 3D spaces linked by a virtual universe. Some describe it as the next evolution in digital connectivity where the value we place on our digital lives begins to outpace the value of our physical lives. The simplest definition comes courtesy of Martin Lau at Tencent. He described the Metaverse as “anything that really makes the virtual world more real and makes the real world more rich with virtual experiences”1.
While the definition is a moving target, what is clear is that we are at the beginning of a shift in how businesses and consumers will interact with web-based platforms.
Q: What are the likely use cases for this virtual universe?
Sung Cho: Use cases are currently limited, as we are in the very early stages of its development. However, companies are starting to experiment with some preliminary use cases, including:
Q: Where do you see investment opportunities connected to the growth of the Metaverse?
Sung Cho: Since the Metaverse is still in its early stages, directly investable opportunities are many years away. However, there are a number of indirect beneficiaries that will see an acceleration in fundamentals if the Metaverse takes off. Those likely to benefit the most include:
Q: On the back of stimulus payments in the U.S. in early 2021, online purchases surged by $8 billion2, and global online retail sales for 2021 grew 27.6% and totaled a record $4.3 trillion3. Even as brick-and-mortar retailers have re-opened around the world, customers have continued to shop online. How are e-commerce companies adapting to the sustained demand and evolving priorities of their customers?
Brook Dane: E-commerce companies are investing heavily in data-driven infrastructure optimization and digital and smart logistics solutions to improve the shopping experience and drive revenue expansion. Fulfillment and omnichannel strategy investments are taking center stage, and they are broadening outside of the retail giants we traditionally associate with these capabilities.
In a direct fulfillment model, which is emerging even among smaller e-commerce players, a company uses its own warehouse management software to unify its network of third-party logistics providers (3PL) and integrate the warehouses with its solutions at the front-end (point-of-sale; payments; loyalty) and back-end (shipping and fulfillment; merchant cash advance; inventory management, reporting and analytics). This optimizes control, cost, quality, speed, and integration in fulfillment.
Q: What are we seeing in terms of increasing competitive dynamics across the e-commerce space and how does this impact investors?
Brook Dane: E-commerce giants are well-established players in fulfillment and delivery, and they continue to grow their presence by aggressively expanding square footage and opening local stations to enable one-day or same-day delivery. Free two-day shipping has become “table stakes” in today’s e-commerce world, with large specialty retailers now offering this service nationwide. Novel partnerships between e-commerce companies and retailers are enabling same-day deliveries, curbside pickup, and ship-from-store options.
Interestingly, we are also seeing a ramp-up of fulfillment investments beyond the Amazons and Walmarts of the world. Smaller e-commerce companies have notably stepped up their investments in the “last mile” according to their unique contexts. In particular, companies with more specialized relationships with small- to medium-sized enterprises (SMEs) are investing to provide differentiated solutions for this client base. Fulfillment is a major driver of churn for SMEs. Investing in fulfillment enables the often smaller e-commerce companies that are focused on these SMEs to protect and strengthen relationships with their highest-revenue customers and maintain high retention.
In such a dynamic and rapidly evolving space, we believe our active investment approach gives us a competitive advantage. Looking along the market cap spectrum and across a broad range of geographies, we are focused on identifying the e-commerce winners of tomorrow: those that have a strong value proposition and moat within a highly competitive landscape.
Q: How has the Chinese online advertising market evolved, and what forces have affected its growth and development more recently?
Nathan Lin: China’s strong digital service ecosystem has been the foundation of the robust growth and high penetration of its online advertising market.
While the growth of the market has been impressive, we saw some regulatory headwinds dampen online advertising demand in the second half of 2021. In the first half of the year, the Chinese government cracked down by establishing more stringent data policies, banning private tutoring, and imposing limitations on online gaming. As the new data protection laws began to take effect, online advertising spending slowed.
On a more positive note, Chinese online advertising avoided disruption related to Apple’s decision last year to require users to opt in to its ID for Advertisers (IDFA) data privacy setting, an identifier that allows the digital ad industry to monitor mobile users’ activity across applications in order to target ads. Apple’s move had a negative impact on digital advertising globally but a more limited impact in China, where we estimate just 8-9% of Chinese mobile users were affected. This is because Chinese internet companies already own much of their users’ data.
And one of the Chinese government’s new policies actually boosted online advertising: when the 25 top internet platforms opened up their ecosystems to each other in response to the government’s new policy to curb anti-competitive practices, the search platforms within that group – namely Baidu – became more valuable to online advertisers. They are now able to generate additional search traffic from the users of other platforms.
For example, e-commerce platform Meituan signed a cooperation agreement with Baidu to offer customers the ability to shop with Baidu’s app after finding a product via its search engine, driving more traffic to Baidu’s site. New partnerships like these have allowed advertisers to start allocating more capital to Baidu’s search service.
Q: What do you expect to see this year in light of these changes?
Nathan Lin: Online merchants are developing more complex systems to manage and interpret their users’ data and, as a result, they are relying less on acquiring user data from external platforms. Since late 2021 we have seen increased advertising spending and improved marketing effectiveness. Among media channels, we expect that social media and short- to mid-form video should continue to outgrow the market, and we foresee e-commerce beginning to see accelerating advertising demand.
While we expect macroeconomic concerns and strict COVID-19 policies across Asia-Pacific and to weigh on growth in the first half of 2022, we think growth will begin to accelerate in the second half. We believe search service providers, short and mid-form video platforms, and social media providers will benefit from regulatory tailwinds and enjoy above-market growth.
Q: The persistently tight supply-demand dynamic in semiconductors is a global issue that you have been monitoring closely given our investments in the space. How does the evolving geopolitical situation in Russia and Ukraine affect this dynamic?
Sung Cho: Concerns about supply disruptions have crept up again in the past few months with conflict escalating between Russia and Ukraine, which are sources of key production materials, particularly semiconductor-grade rare gases.
Noble gases, which constitute a small proportion of the total air in the earth’s atmosphere and can be found in column 18 on the periodic table, play an essential role in semiconductor manufacturing. Russia and Ukraine are some of the largest producers of these gases. These chemical elements, including Neon (Ne), Argon (Ar), and Krypton (Kr), are used in various critical semiconductor production processes because of their unique elemental properties such as electron and thermal conductivity.
Q: What implications will Russia and Ukraine’s roles in producing the noble gases have on investors, given semiconductor companies’ reliance on these production materials?
Sung Cho: Based on our research and discussions with the different supply chain participants, we believe the impact on global semiconductor production should be much more manageable than what some media outlets are suggesting. While semiconductor gases are indeed vital in certain production steps, tool components that hold and use these semiconductor rare gases all have a relatively extended usage life cycle. In the case of semiconductor lithography – the process by which customer circuit designs are transcribed on the corresponding silicon wafers – these rare gases are used as the source of the laser heads and generally have a usage lifecycle of 8-10 months before needing replacement.
Foundries in Taiwan – the largest producer of semiconductors globally – have all indicated that they have prepared enough inventory to manage through the next couple of years. We would also note that semiconductor foundries generally do not directly purchase these gases on their own; equipment and chemical gas suppliers are responsible for sourcing. Our check-ins with leading global gas suppliers suggest that the market has been overly concerned with sourcing from Russia and Ukraine. These companies have recently diversified their supply chains and can now additionally source from countries such as Germany, the U.S., and China.
Q: How have we seen the enterprise communication space grow over time, and what do you envision as the next frontier?
Brook Dane: We have seen several areas of enterprise tech transform themselves over the last decade, adopting next-generation tools that are cheaper, easier to manage, and more readily scalable. However, enterprise communication has not changed significantly. Most audio communication is still carried out through Private Branch Exchange (PBX) systems. These systems lack flexibility and are costly to manage. United Communications as a Service (UCaaS) modernizes enterprise communication by enabling communication through the cloud.
It was only in 2016 that UCaaS began to reveal its promise through initial traction with clients, garnering the attention of the broader industry. As hyperscalers launched their offerings, UCaaS continued to gain further validity and acceptability.
Unlike PBX, UCaaS does not require hardware on site, and the same solution works just as well for 10 lines as it does for 10,000. This is why this solution is cheaper, more scalable, and easier to manage than PBX. Furthermore, it combines video, telephony, and chat within a single interface, making it easy to use one platform for a variety of communication needs.
Q: We have seen the corporate workforce undergo a massive shift during the COVID-19 pandemic, moving from working largely in-person, to working fully remotely, to now blending the two – our new hybrid reality. How have large enterprises deployed UCaaS to help their employees connect in this new environment?
Brook Dane: During the pandemic, video adoption massively increased, with Zoom and several other video solutions being notable beneficiaries. We saw the three different UCaaS subcategories – video, audio, and chat – converge. The most notable examples are Microsoft Teams and Zoom, both of which moved from being just a chat or a video technology to becoming a complete solution. We believe this structure is here to stay.
Next-generation telephony also saw an uptick in adoption, but not to the same degree, as there were several legacy Private Branch Exchange (PBX) lines that needed physical presence to upgrade. We believe that the massive installed base of existing PBX lines will be upgraded to UCaaS over the next several years. More specifically, industry estimates suggest that the legacy base consists of over 400 million PBX lines (seats), of which only about 5% have been converted to UCaaS4. This leaves a long runway for UCaaS adoption.
Any reference to a specific company or security does not constitute a recommendation to buy, sell, hold or directly invest in the company or its securities.
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